Sunday, October 2, 2016

A Look At Next Week's Market Drivers: Deutsche Bank and the Jobs Report

The start of next week will likely be
driven by Deutsche Bank's travails and dollar funding
pressures, which may or may not be related. The end of the week features the US
monthly jobs report. Despite being a noisy,
high frequency time series subject to significant revisions, this report like
none other can drive expectations of Fed policy.

Deutsche Bank is faced with two challenges: its business and
several outstanding legal cases. It is
well appreciated that European bank business model has broken down and
the low, and now, negative interest rate
environment is exacerbating the problems. An important distinction,
however, is that while European banking problems, as in Greece, Italy, Portugal
and Spain, are often made acute by their nonperforming loans, this is not
Deutsche Bank's issue. Only a quarter of its assets are tied to loans, according to reports.

The bank had
what accounts euphemistically call negative revenue last year, which means it
lost money (~7.7 bln euros or ~$8.6 bln). There is a 35 bln euro (~$39.4 bln)
gap between the market value of the bank and the bank's value of its tangible
assets. The bank failed to pass two consecutive stress tests conducted by
the Federal Reserve. Earlier this year, the IMF identified the bank as
the single largest source of global financial systemic risk.

It is the
bank's legal problems that are the source of the immediate pressure, and
roiling the market. There are three numbers that
have caught investors' attention: 6, 14, and 16. The bank's litigation reserves are reportedly near 6 bln euros (~$6.75 bln) The Department
of Justice has proposed $14 bln fine for
fraudulent practices relating to the issuance packaging, securitization, and
sales of residential mortgage-backed securities. The market
capitalization of the bank is roughly 16 bln euros (~$18 bln).

For the
wrongdoing in the residential mortgage space, some banks have been fined more and some less than the Deutsche
Bank's $14 bln fine. Reports suggest that the level of
the fine is not simply a function of the damage inflicted, but also the bank's
cooperation. In addition, Deutsche
Bank has been involved in several other cases, and according to Bloomberg, has
paid more fines than any other bank since 2008.

An unconfirmed
report before the weekend, claiming that Deutsche Bank's fine would be negotiated down to $5.4 bln, saw
a dramatic collective sigh of relief. Risk assets, including Deutsche Bank
stock, financials and equity markets, were propelled higher. The dollar
reversed earlier gains that had sent the euro to new lows for the week. Investors will be sensitive to whether this report is confirmed.

Investors are
particularly concerned about the systemic risks posed by Deutsche Bank. Reports suggest that the gross
notional value of its derivatives book is 46 trillion euros. Many have
warned of a potential Lehman-like event. Contributing to this sense was a
sudden jump in the demand for dollar funding. Since the financial crisis,
several central banks have been auctioning dollars, and there is
quasi-permanent swap line between the Federal Reserve and five central banks
(ECB, BOJ, BOE, BOC, and SNB).

These swap
lines remain largely dormant. Last week, the ECB tapped the line for a $29 mln
(paying 0.95%). The BOJ took one million dollars. Earlier
this year the BOJ had doubled the size of its dollar auctions. Last
week, a dozen European banks borrowed $6.35 bln at the ECB's dollar auction.
This is the most in four years.
Unconfirmed reports indicated that none of the banks were German.

The
implications seem exaggerated by the investors' sensitivity and the some media
accounts. First,
the average of dollar
borrowing per bank at the ECB has been higher. Even the cumulative
amount
is not indicative of a crisis. Second, the borrowings cover
quarter-end. There was an increase in borrowings and participation in
June as well,
just on a smaller magnitude.

Third, part of
the demand for dollar funding may be a function of the dislocation being caused by the new rules regarding US
money markets. The preference for funds that invest
solely in government securities appears to have
driven up LIBOR yields. In turn, this is exacerbating extreme pricing in
the commonly used cross-currency swap
market, where the cost of transferring liquidity or hedging euro and yen
exposure into dollar has risen dramatically....MORE